Should Pay-for-Performance Compensation be Replaced?

Summing up: In spite of its naysayers, pay for performance compensation still makes sense to most of us, according to those responding to Jim Heskett's column on the subject. But there is a difference of opinion of about when and how it works and how it should be structured.

by James Heskett

Summing Up

Let's Pay for Performance … But How?

In spite of its naysayers, pay for performance still makes sense to most of us, according to those responding to this month's column. But there is a difference of opinion of about when and how it works and how it should be structured.

Not everybody agrees, of course. Comparing the simplicity of (especially short-term) responses to the complexity of the pay-for-performance challenge, Ravindra Edirisoorlya went so far as to say that "Current P4P model(s) may lead to another economic bubble and another strong market correction." Phil Clark went even further, commenting that "When you try to institutionalize pay-for-performance you actually ruin the concept." (In fact, there is some evidence that performance pay that is not institutionalized may often be more effective than award systems that are institutionalized.) Helmut Hildebrandt, calling pay for performance "a huge waste of time," said "I think a different logic applies if it (is) used to emphasize team spirit."

Others were supportive of the concept if the proper performance measures could be found. As Jill Machol put it, "There is nothing inherently wrong with pay for performance, only in the way that specific plans have been designed and implemented." Mathews Daniel Kapito helped frame the challenge. As he put it, "People are different… pay linked to performance will only motivate to specific (and presumably individualized) levels." Peter Lee added "The real issue is what you consider to be performance… Performance is all about quality-quality of effort as well as results."

Gerald Nanninga suggested that "let's solve the problem by using non-financial measures." Joseph Violette backed that up with a comparison of two different systems under which he worked, preferring pay for performance "based on my direct impact on profit, relationship with my client, project team performance and development of individual members of my team …"

Joe Schmid commented that "Delinking compensation from financial performance is not an answer. At issue is the short-term/long-term balance of stockholder interests." Srinivasan suggested that a program should contain both. Phillip Gelman added, "If managers were assured that their obs (?) were secure for several years, it might be possible for them to take the long- and proper-view."

Yadeed Lobo articulated the problem faced by corporate boards when he commented that "it is very difficult for board members … to judge relative performance…(it also) involves measuring… (such things as) professional resolve and personal humility." This all suggests that the ideal pay for performance approach should take into account such things as short- and long-term performance, specific individual motivators, effort as well as results, and the context in which performance is being measured. Now put that into the hands of a compensation committee that meets perhaps 10 times a year, and what is the likelihood they'll get it right? We say we should pay for performance, but how? What do you think?

Original Article

Pay for performance sounds right. It aligns managers and investors. It has been the gold standard for compensation at least since proponents of agency theory 25 years ago began advocating the use of stock options in compensation packages. Its use is a source of praise in the evaluation of governance by rating agencies that provide guidance to shareholders in proxy voting.

As a result, pay for performance is almost universally employed in the US and increasingly elsewhere, even though the forms it takes ebb and flow. But now questions are being raised about whether pay for performance at its core is fatally flawed or at least misused.

Mihir Desai, the Mizuho Financial Group Professor of Finance at Harvard Business School, has written recently decrying the practice of tying executive compensation to a company's stock price. He equates P4P to "outsourcing" the appraisal of management to compensation committees—a practice that encourages managers to act for near-term success of the business. This pleases investors who have a short-term interest, at the expense of the long-term performance of the company.

One way to address this issue would be to remove the irrationality of the markets (itself a controversial topic) from the calculation of compensation by linking performance-based pay to numbers such as operating profit. This does not mitigate the argument against short-term incentives. Nor does it address the tendency of compensation committees to rely on numbers rather than judgment. Going even further, perhaps nonfinancial measures, such as those related to product quality, customer perceptions of service quality, or success in developing talent, should be injected in some way into the calculation.

Regardless of the solution favored, Daniel Pink reminds us that all of these practices run counter to a great deal of research questioning the value of extrinsic (monetary) incentives in influencing desired effort, especially if they are routinely expected and aimed at managers who may be relatively insensitive to added monetary awards.

Any effort to inject long-term thinking into pay for performance requires some amount of judgment on the part of those responsible for compensation. For example, awards can be made subject to performance, however it is measured, over longer periods of time. But what is the right length of time? How much of the total compensation should it involve? How is it explained clearly to managers who are not financially oriented? Longer-term incentives involve delays in compensation that may make a job much less attractive to managers with shorter-term needs or interests. On the other hand, it may serve as a way of sorting out managers with a longer-term view of the job.

What we can conclude from the discussion is that no single approach to paying for performance fits every organization. But the discussion suggests several pertinent questions:

Should pay for performance be decoupled from company valuation? Should more judgment on the part of compensation committees be required in determining performance pay? Or does this introduce new potential problems to the process? Can the effectiveness of pay for performance be improved by extending payout periods or determining performance on non-financial criteria? Or should reliance on pay for performance be reduced in the total compensation package?

Referring to Makunda's article, a "filtered" CEO often is in Mary Matalin's term, "an egocentric narcissistic sociopath". We hire for that trait, expect Pavlovian performance for pay and just as often get a suit with many pockets. An "unfiltered" CEO upsets, disturbs, and is driven not by pay for performance but by the rate of change, good or bad. We don't hire them because it's risky to the Board and terrifying to boys just below the filter. We wind up with our worst choice, pay them a fortune because CEO's have no idea what they're worth unless someone else is paid more. Monarch butterflies have greater longevity.

We shareholders? We're out of the loop. Trillions of cash isn't paid as dividends, isn't invested in the company, and CEO performance is often based on earned income diverted into derivative pools making higher returns than operating the business the way they do.

Hire a school teacher to run a Fortune 500 company. See what happens. Scare the hell out of the feeders. Pay fair dividends. See what shareholders do. If a volunteer Harvard community organizer can beat the pants off of a Harvard Bain superstar, maybe we're just mistaking performance for theater.

Ravindra Edirisooriya

Accountant 11/14/12, Midwestern Small Business

Professor Heskett's question "Should pay-for-performance compensation be replaced?" is very timely given this period of great economic (income) inequality in our society. The central assumption (hypothesis to be tested) of Professor Desai's thesis is that P4P maximizes short term performance over long term performance of a company. The solution space of Professor Heskett's question is at least seven dimensional: decision metric (sufficient or acceptable long term performance/insufficient or unacceptable long term performance, alternatively, not replace P4P/replace P4P), pay metric (continuum of compensation packages), performance metric (financial, product quality, customer perceptions, service quality, talent development, other non-financial measures and triple bottom line), time (short term, medium term and long term), managers' ethical/moral behavioral metric (ethical/moral, unethical/immoral), financial rules and regu
lations metric (relax, tight), and judicial prosecution of financial (white collar) crimes metric (easy acquittal/slap on the wrist tendency, strong conviction/hard labor tendency). Data could validate this model. Data cloud densities and probability theory (statistics) may provide scientific answers (may provide different answers in different subspaces of seven dimensional space) to the follow-up questions and main question: Should pay-for-performance compensation be replaced?

Current P4P model may lead to another economic bubble and another strong market correction, if unchecked/unadjusted. Economic bubbles are never ending ...

Yadeed Lobo

We can manage what we can measure. So some form of performance based pay should exist. Whether it is for a teacher, a doctor, an engineer or a manager. Collective agreements usually have an inflation indexed increment relative to performance so that would be a good start.

However, what's needed is a cap on the level of executive pay as a multiple of what an ordinary employee earns. This way outsized incentive packages can be controlled for.

Decoupling pay from company valuations is an excellent idea.

However, it is very difficult for board members (on compensation committees) to judge relative performance. And relative performance contracts could be bad for industry profits. Another conundrum is when you have a Chairmanof the Board/CEO who are one and the same person.

Judgement involves measuring (from Jim Collins) professional resolve and personal humility. Both extremely hard to capture on a mathematical scale. I feel the greatest/ principled leaders are usually born/made out of the most difficult circumstances. That is what tests true mettle.

It is interesting that Prof. Mihir Desai elucidates the role/importance of context in explaining outsized pay packages. So perhaps when evaluating candidates for executive positions board members should see the context/development opportunities in which a potential candidate earned his/her spurs. Sometimes perseverance in adverse circumstances can be more revealing then pedigree in favourable environments.

David Wittenberg

CEO, T

I love Ravindra's analysis in Comment #2.

The question is, essentially, merely a restatement of the agency dilemma. How can the interests of the CEO be aligned to those of the shareholders? My answer: Creativity is needed in CEO compensation design to improve upon past systems.

If performance metrics were abandoned, all judgments of CEO performance would be subjective. I submit that this situation would be less likely to solve the agency dilemma.

So, if performance metrics are required to motivate CEOs to run the company with the shareholders' interests in mind, the remaining question is which metrics to choose. Past compensation plans have produced predictable results, including juggling the books and stressing short-term results over long-term results. Clay Christensen's adage that ultimately, all corporate failures have as their root cause the prioritization of short-term over long-term results, provides a strong caution against repeating past measurement systems.

The parameters in Ravindra's posts are all polar -- they involve value judgments and trade-offs. Replacing the existing metrics with others might produce nothing more than the opposite set of problems. In my view, there is no single parameter that will be effective. Each board must determine its priorities. The ideal solution for some companies might turn out to be a balanced scorecard.

Phil Clark

Clark & Associates

Pay-for- erformance has been the biggest scam in business ever purpetrated on employees. They see people being promoted because of who they know who can BS the best. They see CEO's come in and wreck their world and often the company and walk out untouched. How many CEO's are paid a percentage of a base salary depending on stock performance? Stock goes down, salary goes down. Performance is in the eye of the beholder, but most often does not relate at all to the core and base employees that make a company successful. Dilbert has made an industry out of observations of corporate behavior. The Office has been a popular show in England and the U.S. We all laugh because to take the business pay-for-performance mantra seriously would make us cry. When you try to institutionalize pay-for-performance you actually ruin the concept. I knew a situation where an individual was given a big performance bonus. All the people who picke
d up his work while he focused on a single project were really upset because they received no recognition. So they failed to show up and work for a week. They were then threatened with termination because they were costing the company money. They made the point that without them, the other individuals performance was worthless. Just remember to recognize everyone that contributes to success.

Finally, the nail in the coffin for pay for performance is the statement by leadership that, "We have only so much money to pay out for bonuses this rear, so you can only give a performance bonus to xx employees". You just killed the program.

Jill Machol

Compensation Manager, Providence Hospital

There is nothing inherently wrong with pay for performance, only in the way the specific plans have been designed and implemented. People do what you pay then to do. Therefore, if you want to incent both short and long term performance, you need to set up the P4P plan to include both. This can easily be done using a rolling average over a specific period of years (3, 5, 10 or more). In addition, other elements that cover quality, staffing, and other management issues can also be included because a P4P plan can be multi-dimensional. The other aspect to consider is that no CEO creates value for the company alone - all of the other employees of the organization have a role - so that some of the incentive payments really should be shared throughout the organization.

Phillip Gelman

Managing Partner, MoneyInTheTill.com

If managers were assured that their obs were secure for several years, it might be possible for them to take the long - and proper - view.
If listed companies had the guts to ignore stock analysts and funds, they might be able to explain to their stockholders what they are attempting to do.
Few have the guts to say that the next few years are for building, not generating dividends, chances are that individual stock holders will go along.
Funds probably will not and the system will not change.

Srinivasan

Director, HP

"Pay for Performance"... That's what it should be - at all times. I think the real issue is not one of Pay for Performance - but in deciding the appropriate performance measures and then the appropriate compensation structures.

Today P4P has become synonymous with quick payouts for short term "apparently visible" results.

So ideally the P4P should be a combination of short term results - where items like cash flow/ operating profits should be used to measure. Whereas the long term goal of growth and secular profilts/ margins - should result in equity type of compensation.

Long term results and long term compensation to a good extent should survive the departure of the person from the org.

What gets measured, is what drives people's behaviour.
Also the more "smarter" the people (assumption on the senior leaders of any corporate), they will want to work to the easiest way to reach the pot of gold. When systems are designed inappropriately - they naturally lead to inappropriate behaviour/ action by people.

So until P4P is properly implemented, it will be a challenge.

Kapil Kumar Sopory

Company Secretary, SMEC(India) Private Limited

P4P implies, in a sense, that people are even paid for non-performance. If not, there should be no pay for non-performance.
When you hire someone, the agreement is that he will do this and that. If he doesn't, penalties, monetary as well, need to be prescribed. That is going to introduce loyalty and dedication.
We lament loss of productivity. Who is responsible? Managements which provide opportunities for taking jobs without the seriousness they deserve. At this period of high unemployment, enforcing discipline should not be a rocket science.
Some incentive may, however, be provided to those who deliver more than their agreement provided it indeed gives real value to the organisation.
But it is not P4P.

Peter Lee

Mg Consultant, RDS

The real issue is what you consider to be performance.

Performance is not the same as outcomes especially those that are measured. Performance is all about quality - quality of effort as well as results.

There are two problems here.

One is the difficulty of capturing all relevant aspects of the performance e.g. every manager should be paid for increasing the performance and/or the value/output of his unit but often this performance is captured only in very narrow terms - like quantity of short term output & not the equally important quality of working behaviours & learning capacity of his unit.

The second problem is the overwhelming size of the incentive package. For example, no level-headed manager will cheat or manupulate accounts if the extra incentive is, say, 10% or even 30% of his current salary but if he stands to make millions in incentive awards it is an entirely different matter.

And, because the bubble-like market metrics created bubble-like incentive awards, these lob-sided awards in turn created lob-sided behaviours.

So my take is that the real issue is that incentives were not properly designed, what took place was probably a cut and paste approach.

Joe

Schmid, Oak Leaf Consulting Llc

The Board of Directors is accountable for the corporate mission and its governance. BOD Compensation Committee is accountable for a compensation framework that supports the mission and the interests of the stockholders. Performance is defined in the context of mission. In business everything from employee morale to customer perception can be measured with money. Delinking compensation from financial performance is not an answer. At issue is the short-term / long-term balance of stockholder interests. The correction (if any) lies in the Compensation Committee's Charter; and the stockholder mindset of "What have you done for me lately."

Mathews Daniel Kapito

Director, Centre for Corporate Management and Finance

Pay and performance has been seen to increase productivity for ages. I have always looked at the classical theories and my own business theories, but have always made a conclusion that pay linked to performance will only motivate to specific levels. People are different. I personally Im motivated by achievement, this means that my company benefits more as I strive to achieve set goals. However, if I get a reward for achievement, I set greater challenges. People are different, some would rather get more even if they are failing.I believe peple need to be given incentives that increase their productivity.
In my opinion I would appreciate paying executives based on productivity, but always remember the contradiction that comes as executives depend on their subordinates. The question is, Should all staff be paid based on performance?

Dennis Hopwood

Director of Human Resources, Whitman College

Board compensation committees are notoriously populated by ex-CEOs whose reward philosophies are biased by their own experiences. Those experiences, in turn, have been shaped and informed by compensation consulting firms that feed the competitive beast of ever-escalating peer comparisons. Pay for performance has astonishingly little relationship to executive compensation these days. The system is broken, due in large part to Boards that are paid to much to do too little.

Executive compensation is an art form that should seek to achieve balance and tension between short-term company imperatives and long-term value objectives. Leadership should be resolutely biased toward achieving long-term goals and resisting the pressures of Wall Street to produce short-term upticks that reward the ADD proclivities of investment managers.

Long term incentives, which should comprise the largest portion of an executive's total compensation should be socialistic. That is, based wholly on team accomplishment of non-gamed metrics and enterprise goals that force fiercely individualistic execs to work together. Shared pain, shared gain. Base salary and short-term incentives, on the other hand, should reflect market-based differentiation and strong performance measurement at the individual level. Under no circumstances should stock price ever enter into the compensation equation for executives.

Helmut Hildebrandt

CEO + Owner, OptiMedis AG

Isn't P4P especially with all this even more calculations over more years and other BSC-type figures just a huge waste of time and creativity better spent on improvements of quality, services and productivity? The arguments against P4P derived from behavioral economics research questioning the value of "monetary incentives in influencing desired effort, especially if they are routinely expected and aimed at managers who may be relatively insensitive to added monetary awards" quoting Prof. Heskett are strong enough to reduce P4P, at least for individuals. I think a different logic applies if it used to emphasize team spirit. Or what is your impression?

Gerald Nanninga

Principal Consultant, Planninga from Nanninga

Would we ever want to pay someone to non-perform? Of course not (unless you count paying farmers not to plant crops). So you want people to perform. And you want incentives to encourage performance.

The problem is that we like to use financial scales to measure that performance--like stock price, profits, sales, etc. We have all seen the weaknesses to these measures and how people can "game the system."

So let's solve the problem by using non-financial measures. First determine what key tasks and key outcomes you want the individual to deliver that year: like landing a key account or developing a new product or delivering a key initiative. Second, if that performance is delivered, there is a bonus; otherwise no bonus.

That is true pay-for-performance: the performance of the individual rather than the performance of the company financials.

raghubabu

Managing Partner, R & A Associates

I fully conquer with the views of the author. Simply linking compensation to numbers can defeat long term objective of the firm. Qualitative parameters have to be considered for p4p.

Joseph Violette

Manager of Projects, Nuclear, Bechtel Corp. Retired

Performance is a broad measurement and covers much more than just some individual's assessment.

I've worked under two difference systems at different companies: one where pay was based on my immediate manager's performance appraisal (16 years) and the other based on my direct impact on profit, relationship with my client, project team performance and development of individual members of my team (35 years). I performed much better on the second system and it was a heck of lot more fun.

Don Robertson and Donna Goss

Co. Dir. Leadership Development, Center for Business and Industy @NCC

One of the themes that surfaces in all these thoughts is that if P4P is going to have a meaningful and positive impact on organizational performance, it must find a better balance between short and long term goals serving as the basis for measuring the performance to be rewarded. In addition is the sensitive subject of who is included in a P4P process and how do you reward the people who should actually be doing the day-to-day work.

Ideally, a high performing organization has leadership that sets a direction that defines success for the long term with short term goals and objectives to serve that future. Then that leader empowers the next level in the organization (who have been involved in setting the direction) to deliver. The teams that make up the organization deliver because they are committed to success and believe their performance matters.

I used the word "ideally" because we don't see that model except in a very few truly high performing organizations. As Daniel Pink says, there is what research knows and then there is what organizations actually do and they usually are not the same. There is a link between "ideal" and success and it can be done because some have done it.

So in my mind, if people focus on what they are rewarded for and they are rewarded for the the "ideal" that has been documented by many as seen by the comments in this discussion, then P4P will work more effectivley. That is easier said then done but it certainly means more emphasis on the long term and building a more comprehensive system that rewards executives and managers for leading and team members for delivering.

Phil Clark

Clark & Associates

I am a bit disappointed with some of the assumptions made here. Is our performance vision so narrowly focused that money is the only measure? Some of the most dedicated work performance I have witnessed were from soldiers who have laid their life on the line for pay many here would laugh at. Our astronauts were well paid, but nothing like corporate leaders. Thankfully many went on to better financial rewards for their accomplishments. Those astronauts with whom I have visited did the job because they loved it...not for the money. Pay for performance was not even on the horizon. In fact, increasing pay often deters performance. Some have hinted at that in this blog. How many times has a "franchise-making" ball player ...only created a team that performed poorly?

There is no easy way to dole out money for performance. What concerns me is that maybe we do not move enough money down to those who really build and support the company. Don't get me wrong...leaders are valuable and bad leaders are a disaster. But I am concerned that are sense of reality for executive compensation had become skewed. If only the CEO shows up for work, what happens to the company?

Paul Guard

CEO, Coastal Pro Enterprises

I have been in the manufacturing business over 32 years and have had a "pay for performance" system in place in all but the years with very low sales and production. My business was Action Craft, a boat building business I sold earlier this year. I agree that the same structure of pay for performance systems is not going to work in all businesses. I developed a system that saved my business more than once. When I re-introduced the system at different times, production always became much more efficient. The difference was extraordinary. We would see production increases of 25% to 30%, with fewer employees. At the same time, employees that produced under the pay for performance system would see their pay go up. There was criteria the employee needed to meet to earn the most money. The quantity, quality of their work and attendance were the important criteria that made up their pay. I am getting ready to launch a n
ew business soon. You can bet I would not even think of manufacturing a product without having a "pay of performance" system.
Best Regards,
Paul Guard

Anonymous

The concept totally relates to what is defined as 'performance'. If one preforms by the measurement criteria, one reaps the rewards. The concept of pay for performance is well understood and applied in many industries, however measurement is the variable.

The fundamental analysis is measurement, if nothing is measured against reference point, then the basis for a bonus becomes an abstract view - there is no sound measurable justification. Thus in simple terms the evaluation criteria reverts to "Did you do a good job" and in a yes/no world it bonus or no bonus.

A totally radical view would be to pay everyone in the company the same base and supplement pay based on measurable performance in both directions - i.e. if the CEO preforms then it filters down and if the workers perform it filters up via the teams.

Fundamental accountability - maybe radical but would it work - I think it would but - I ask this column for their views

Anonymous

After implementation of Pay for performance in a government run PSU, P4P damaged trust between the employees who are managing and who got managed by others.Mistrust once started and grown, leading to show up with out doing any real important contributions, everybody wants to show artificial results,only in short term. i had seen from very close how our divison(Multi disciplinary team, who rates others from discipline got low performance ratings, stopped delivering results) finally closed, there is no new initiative has been taken up.
In fighting among working level employees, who desperately want to get financial benefits, got aligned with bosses, discarding immediate bosses, maligning images of one another, end result is we don't have any divison to work.
Uniform payments among the ranks, non money payments such as giving award, recognising the whole team as such will do less harm

Alan Frederickson

President, AF Capital

Too often P4P is structured like a new theory of relativity. It is created with a set of variables to the right of an equal sign and the resulting pay is determined mechanistically in accordance to someone's derivation of that new equation.

It is important to make sure that an executive who works hard is fairly compensated in such a manner that s/he knows that they will be compensated if they successfully expend the effort and apply their skills to get certain things done.

However, an equation needs to be humanized where the CEO or the Board or upper management can adjust the result on the basis of certain QA and personal characteristics that can either increase or decrease the mechanistic formulated pay.

For instance, a CEO may surpass expected growth in shareholder values and deserve substantial bonuses by the P4P formula. However, in so doing that CEO may also have abused key executives who left the company creating a significant vacumn of talent that was to have been the backbone of the company's future. The results today do not measure the damage that was done for the future. In this case, the incentive P4P pay should be reduced -- perhaps substantially.

At any level, the P4P formulation by equation is a very positive incentive for executives to invest their time and skills at the expense of all their personal needs. It allows executives to know how to evaluate the cost/benefit of their personal sacrifice.

However, the company must also ensure that the accomplishment of such goals AND the way it was accomplished do not sacrifice other needs of the organization as a whole.

Therefore, a P4P formulation is good as long as it is not rigid. Management above the executive under evaluation muct be able to adjust a significant portion (20% to 50%?) of the P4P pay by "soft varibles" that are known by all the parties but are measured by management above the executive.

Anonymous

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